Which business structure makes the most sense for your startup? This may seem like a pretty straightforward question, but there’s a lot to unpack here. The decision to form either a C-corporation, a limited liability company (LLC), or a different corporate structure can have consequences that affect everything from taxes to future investment opportunities. You’ll also need to think about how much flexibility you want and how big your appetite is for paperwork.
But we’re getting ahead of ourselves. Before you choose a C-corp vs. LLC, it helps to understand how each business structure works. Both entities can help to protect you from being held personally liable for your startup’s debts and losses, but each has its own advantages and disadvantages to consider. And in some cases, it may even make sense to switch from an LLC to a C-corp as your startup’s needs evolve. Let’s take a closer look.
C-corp vs. LLC: At-a-glance comparison
What is limited liability protection?
What is a C-corp?
What is an LLC?
When to form a C-corp vs. LLC
What is limited liability protection?
Before we dive into all the ways a C-corp and LLC differ, we should explain one big thing these business entity types have in common. Both of them offer limited liability protection. This means that the business owners are generally protected from having personal liability for any debts and obligations belonging to the business.
This is a big deal! Say you own a startup that specializes in providing cybersecurity services to other businesses. If one of your customers is hacked and loses profits as a result, they might hold your company accountable and attempt to recover some of your assets as compensation—even if your company wasn’t at fault or acting negligently. They may well be able to recover their losses from your company’s assets, but if your business is organized as an LLC or C-corp, they generally cannot hold you personally liable and seek your personal assets.
So, if you’re an owner, shareholder, or member of a business with limited liability legal status, you typically don’t need to worry about being turned upside down and drained of your personal assets if your company runs up debts or faces a lawsuit. Creditors generally can’t collect debts for an insolvent company from the personal assets of that company’s members—management, owners, or otherwise. But this doesn’t mean you’ll feel no pain at all. Limited liability status limits your risk to the amount you’ve invested into your business, which can still be a considerable amount.
What is a C-corp?
Before we get into what a C-corp is, it’s probably best that we define what a corporation is. Why? Because a C-corp is a tax classification commonly used by corporations.
A corporation is a legal entity that is separate and distinct from its shareholders, directors, and officers. You may remember Mitt Romney’s assertion on the 2012 campaign trail that “corporations are people,” and, in the strictly legal sense, he was right: a corporation is considered a legal person separate from the individuals who comprise it.
With great legal power comes great responsibility, so corporations are generally subject to more rigorous and complex requirements than other types of businesses. For example, a corporation must have corporate bylaws, conduct annual meetings, elect a board of directors, and follow strict rules regarding record-keeping.
A C-corp is a corporation that’s taxed separately from its owners. This can lead to the issue of “double taxation,” because a corporation must pay taxes on its earnings and its shareholders must also pay taxes on dividends distributed at the individual level. This means that the dividends are essentially taxed twice—first at the corporate level, then at the individual level. Corporations of a certain size (fewer than 100 shareholders) may elect to have S-corp status and avoid the double taxation issue, but even a C-corp may be able to find deductions and other ways to make the additional tax burden less painful.
Despite some of the potential drawbacks, forming a C-corp can make the most sense for businesses of a certain size and level of ambition. We’ll get to some of the main benefits of forming a C-corp shortly, but first let’s discuss what the formation process actually looks like.
How to form a C-corp
Setting up a C-corp typically involves filing articles of incorporation with the appropriate state agency that oversees corporate filing. These articles of incorporation include some basic but crucial information about your company, including its name, address, and the type and number of shares.
Forming a C-corp can get more complex from here. Aside from filling out the info required in the articles of incorporation, you’ll also need to create a set of corporate bylaws, elect a board of directors, hold board and shareholders’ meetings, and issue your first shares of stock. The good news is that many law firms and services such as Clerky offer a templatized set of these documents and assistance in filling them out, so it’s not quite as difficult to get started as a Delaware C-corp as it may sound.
What are 3 key advantages of forming a business as a C-corp?
Forming a C-corp can be a time-consuming and expensive process, sure, but there’s a reason why so many businesses do it! While not the simplest route, it offers some key benefits that an LLC can’t:
Forming as a C-corp is basically a must if you want to raise venture capital. Many startups have big plans to grow and grow and grow. But in order to do that, they need to raise a ton of capital. Venture capital firms and other investors typically have a strong preference for C-corps over other business structures. For one, their management structure is predictable, defined, and subject to rigorous compliance requirements. Secondly, C-corps are taxed in a more investor-friendly way since investors only pay taxes on money distributed to them (vs. LLC members, who pay taxes on gains even if they aren’t paid a distribution). If you’re interested in going through multiple funding rounds, you’ll likely want to start planning to incorporate as a C-corp.
C-corps can offer equity compensation to employees. Being able to issue stock also comes with an advantage for attracting talent, as equity compensation is one of the better recruiting and retention tools out there. C-corps can issue stock, while LLCs can only offer profits interest (which somewhat mimics the economics of stock options, but isn’t the same as equity). This is something to consider before taking the simpler path.
C-corps are generally better for internationally oriented businesses. If you’re interested in expanding your business globally, a C-corp can offer better and more predictable legal protections than an LLC. In any case, international jurisdictions and investors will likely have less trouble wrapping their heads around a C-corp than they would an LLC.
What are 3 key disadvantages of forming a business as a C-corp?
We’ve already touched on several of these, but let’s review some of the reasons why it might not be in your best interest to form a C-corp:
C-corps may face double taxation. C-corps must pay taxes at the corporate tax rate on their earnings first, then their shareholders must pay taxes on distributed profits.
C-corps require more record-keeping and compliance. Whether all of these regulatory requirements are worth your time and expenses will depend very much on how much you need the benefits a C-corp can offer. In any case, you should be prepared to adhere to the rules and regulations involved in running a C-corp before diving in.
Shareholders can’t write off losses on their personal income tax returns. Since C-corps are taxed separately from their shareholders and are not pass-through entities, shareholders can’t write off losses on their individual tax returns.
What is an LLC?
A limited liability company (LLC) is a type of business entity that protects a company’s owners from personal liability for any debts and/or losses that the company accrues.
An LLC is a bit of a hybrid legal entity, in the sense that it has certain things in common with a corporation and certain other things in common with a sole proprietorship or partnership. Like a corporation, an LLC offers limited liability protection. Like a sole proprietorship or a limited or general partnership, an LLC is typically able to “pass through” taxes to its members, who can recognize any business profits or losses on their personal tax returns.
One very appealing thing about LLCs is that they’re one of the simpler business structures to form. If you’re a startup founder looking for a relatively straightforward way to protect yourself and your fellow business members from personal liability risk, an LLC can be a good option to consider. LLCs also come with a good deal of freedom and flexibility in terms of their ownership, management structure, and reporting requirements —at least relative to corporations.
How to form an LLC
LLCs operate under the jurisdiction of state law. This means you’ll need to check with the Secretary of State in the state where you’re considering incorporating your business to determine the exact process for forming an LLC. In general, most states will require you to file articles of organization, which is a legal document that includes basic information about your business, its members, and its purpose. You may also have to pay state fees when filing articles of organization.
After completing the initial steps to set up your LLC, it’s generally recommended that you also create an operating agreement that outlines the various LLC members’ rights, roles, and responsibilities (this is more straightforward if you have a single-member LLC). LLC operating agreements aren’t required by law in every state, but they can help protect and validate the company’s status. They also give the various different LLC owners clarity in terms of their specific ownership percentage and their share in the company’s profits and/or losses.
What are 3 key advantages of forming a business as an LLC?
LLCs are popular among entrepreneurs and small-business owners for a reason. They provide a lot of flexibility and generally require less record-keeping and regulation-following than corporations. Here’s a quick breakdown of some key advantages associated with LLCs:
Members get liability protection. Yeah, so, we’ve already covered this. But it’s worth restating: One of the primary benefits of forming an LLC as a startup founder is giving yourself a relatively simple means of protecting your personal assets against debts, losses, and potential lawsuits targeting your business.
It’s easier to stay compliant. You can essentially choose a management structure for your LLC as you see fit. An LLC can be managed by its members, by a group of managers, or by a member designated to act as the manager. The management requirements for an LLC are generally less formal than those of a corporation, giving you more flexibility to choose a management structure that makes sense for your business.
An LLC can “pass through” taxes to its members. For some, one major benefit of forming an LLC is the “pass-through” tax structure. It’s called “pass-through” because profits and losses from the business are passed through to the personal income of the LLC’s members—without being subject to corporate taxes. An LLC can opt to be taxed as a C-corp in certain cases, but this is not very common because C-corps face double taxation (earnings are taxed first under the corporate income tax rate and then at the individual level when shareholder distributions are made).
What are 3 key disadvantages of forming a business as an LLC?
There’s a lot to love about LLCs, but that doesn’t mean they’re right for every type of business. Here are some downsides that exist with LLCs, one or several of which may be significant enough for a business to consider a different structure:
VCs usually won’t invest in LLCs because of how they’re taxed. LLC taxation can be a big turn-off to VC investors, because LLC members are taxed on gains even if they aren’t paid a distribution. C-corp shareholders, on the other hand, are only taxed on shares when they sell or receive a distribution (e.g. a dividend). In general, investors don’t like to pay taxes on profits if they aren’t receiving any money in their pockets. Makes sense.
LLC members must contribute self-employment tax. The members of an LLC are considered self-employed for tax purposes, meaning they must contribute self-employment tax payments toward Medicare and Social Security.
Things can get tricky for LLCs operating in multiple states or countries. Because LLCs operate under the jurisdiction of state law, an LLC that operates in multiple different jurisdictions may have some additional headaches and paperwork on its hands. Generally speaking, businesses that operate in multiple states or jurisdictions may be better suited for a different type of business entity.
When to form a C-corp vs. LLC
If you’re wondering which business structure makes the most sense for your startup, you have a lot to consider. Startups set on raising money from investors in the interest of one day going public may want to get the ball rolling on C-corp status, but small business owners with more modest ambitions might find an LLC more suitable to their purposes.
And it’s not as if you can’t form as an LLC first and later elect to transition to a corporate structure. In fact, this could make a good deal of sense for businesses that value flexibility and simplicity in the short term but know they want to ultimately rely on equity financing to get from here to there. Flipping from an LLC to a C-corp does cost money, so it’s not as if this is always the most obvious decision in the world—but there are cases in which it can make sense.
Wherever you’re at in your startup journey, Pulley is here to help. Our cap table management platform makes it easy for corporations to keep track of the equity they issue and avoid costly mistakes when raising funds. Schedule a call with one of our experts today, and let’s chat about equity.
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